Option Expensing: The Time Is at Hand

November 21, 2005

By Howard Silverblatt "All costs of wages, salaries, and benefits for people involved in a business' operations should be charged to the business." With that statement on Nov. 7, 2001, Standard & Poor's launched S&P Core Earnings, and with it the belief that option expense should be included and reported in earnings.

Flash forward four years, and Corporate America is bracing for a similar shift: Starting with fiscal 2006, all companies are required under the Financial Accounting Standards Board's (FASB) new rules to expense options. The question is: How they will be reported?

LINGERING CONTROVERSY. We at Standard & Poor's have made our approach clear. In order to insure the timely and proper dissemination of information, Standard & Poor's will include option expense in all of its earnings, and our equity analysts will include option expense in their forward estimates.

The use will be uniform and universal. The investment community benefits when it has clear and consistent information and analyses. A consistent earnings methodology that builds on accepted accounting standards and procedures is a vital component of investing. By supporting this definition, Standard & Poor's is contributing to a more reliable investment environment.

The new accounting rules that require companies to expense option cost against earnings remain controversial, and will continue to be discussed for years. The regulations, however, have been passed, and are effective for fiscal 2006. The current debate as to the presentation by companies of earnings that exclude option expense, generally being referred to as non-GAAP (generally accepted accounting principles) earnings, speaks to the heart of corporate governance. Additionally, many equity analysts are being encouraged to base their estimates on non-GAAP earnings.

DIMINISHED FAITH. While we do not expect a repeat of the EBBS (Earnings Before Bad Stuff) pro-forma earnings of 2001, the ability to compare issues and sectors depends on an accepted set of accounting rules observed by all. In order to make informed investment decisions, the investing community requires data that conform to accepted accounting procedures. Of even more concern is the impact that such alternative presentation and calculations could have on the reduced level of faith and trust investors put into company reporting.

The corporate governance events of the last two years have eroded the trust of many investors, trust that will take a long time to earn back. In an era of instant access and carefully scripted investor releases, trust is now a major issue.

S&P encourages all reporting entities to conform to the spirit of the regulation and present earnings including option expense. S&P also encourages companies and analysts to present, in a clear tabular format, specific option expense cost when it is deemed significant.

WATERSHED EVENT. Options have become a popular tool and their issuance, once restricted to top management, has grown to include a broad array of employees. Market studies and academic research have attempted to quantify the benefits of options, but controversy surrounds the issue of whether options are top-heavy, in favor of upper management.

Additionally, recent events have highlighted the conflict of having a short-term equity stake in a company that you also have a responsibility to for public reporting.

Up until 1992, companies were not required to expense options in their income account. In 1992, the Financial Accounting Standards Board attempted to require companies to expense options, but the U.S. Congress blocked it.

DAWNING REALIZATION. The discussion about expensing options remained through the bull market of the late 1990s, and options became more prevalent, especially in the Information Technology sector. When the bear market started in 2000 and earnings began to fall, option cost soured as a percentage of earnings. With the use of pro-forma earnings, corporate governance emerged and a backlash against what was considered improper reporting.

It was at that point that S&P launched Core Earnings. The most controversial component of Core Earnings was the expensing of stock options. As the market continued to slide, many earnings reports still appeared healthy, and reports of multimillion dollar option deals became more prevalent. The realization that option expense was real grew in both the public and corporate view.

The FASB addressed the issue by requiring additional disclosure, and worked on regulations requiring them to be expensed. In December 2004, it issued FAS 123R, requiring companies to expense options starting with fiscal periods beginning after June 15, 2005.

REDUCED TAX LIABILITY. The logic behind expensing options remains basic. Options have value: both currently, as a potential play on equity, and (hopefully) during the term of the option when the stock price rises above the strike price. S&P views stock option expense as a component of salaries, and as such, classifies it within the cost of goods sold. S&P does not determine the value cost of options, but utilizes the value as determined and reported by the companies in their 10Q and 10K filings.

When companies issue options to their employees, they are giving them a right. This is a noncash item and there is no actual exchange of cash. The company calculates the value of the options, using methodology similar to that used for evaluating a market stock option, and charges that cost against its expenses. The company then utilizes the cost in its tax calculations, which results in a reduced tax liability; this is a positive cash-flow item.

Analytically, ratios are calculated with and without option expense, as they are with many other items (such as taxes and interest). The higher the option expense, the more relevant its separation and analysis are as a stand-alone item.

SHORT-TERM DISRUPTION. Ideally, the stock of the company at somepoint trades above the option strike price and the employee exercises the right, triggering the company's contingent liability to fulfill the option. In general, companies will either issue a new share (therefore diluting earnings and existing shareholders equity) or, more commonly, go into the open market and repurchase shares. The difference between the exercise price and the market price is the cash cost to the company.

Buybacks within the S&P 500 have skyrocketed over the last year, setting new records. For the first half of 2005, S&P 500 buybacks amounted to $163 billion, a 91% increase over the $85 billion posted in 2004.

The new reporting requirement is effective as of fiscal 2006. While some off-calendar year companies are already required to expense their option-related costs, most will not start until 2006. This phase-in will create a short-term disruption in the comparison of issues. S&P is maintaining option expense as a separate data item that can be used to adjust historical data for comparative use. In addition, some companies have accelerated their options, which will initially reduce their option expense for fiscal 2006.

DECREASED EARNINGS. In 2002, option expense, which was excluded from earnings, represented 14% of operating and 22% of as-reported (i.e., GAAP) earnings. Since then earnings have significantly improved, with operating earnings posting 14 consecutive quarters of double-digit gains. The result is that, as a percentage, option expense now represents a much smaller (but still significant) component of earnings.

The impact of option expensing on the S&P 500 will be noticeable, but in an environment of record earnings, high margins, and historically low operating price-to-earnings (p-e) ratios, the index is in its best position in decades to absorb the additional expense. Historically, over 95% of the companies in the S&P 500 have had option expense. This number started to decrease as it became apparent that option expensing would be mandated.

As the date approaches, several companies have chosen to accelerate their options, thereby recognizing the expense now in their footnotes instead of in fiscal 2006, when it will be reported on the income sheet. Based on 2004 fiscal data for the S&P 500, as-reported earnings would have been reduced by 4.4% if all option expense had been counted in.

FOOTNOTE LOGIC. A total of 114 issues omitted option expense, which would have reduced their as-reported earnings by at least 10%, and 12 issues that reported a gain would have reported a loss. The median change for 2004 was 4.55%, with the average being 17.91%; however, excluding issues with option expense over 25% of their earnings, the average was 5.61%, which is more in line with the median.

The impact was felt most in the Information Technology sector, where unexpensed option cost would have reduced as-reported by 19.19% and operating by 17.79%. Option expense is a characteristic of the Information Technology sector, the same way low (relative) margins are to supermarkets or high returns on tangible book values are to drug companies. These characteristics are due to the type of business and environment the issues operate in. When appropriate, S&P 500 characteristics may include footnotes to quantify the specific impact of a sector.

This expands the ability to compare issues and sectors that do not contain these specific characteristics. In order to support research and historical comparisons, S&P has incorporated unexpensed stock option cost into its database and included it in its products. S&P equity analysts are including the expense in their estimates and, when pertinent, stating the value in a per-share amount along with their estimates.

EMERGENT TRENDS. The change in accounting rules permits a clearer understanding of the cost of salaries and benefits. While the costs were always there, the change is that they are now reported on the income statement. With the costs now being reflected on the front page of income statements, as compared to the traditional footnotes, companies have become very aware of the additional attention given options and the general perception of the issue by the investing public.

Several new related trends focus on total value returned to shareholders. The first, which is a dramatic shift, is the use of stock buybacks to reduce the actual share count, rather than just satisfy option issuance. Share reductions add to existing shareholders equity, and increase future earnings per share. Share reductions are also cumulative.

If a company reduces its share count by 1% for three consecutive quarters, you can expect (all things remaining the same) that fourth-quarter earnings would be 3% higher. Since most of the attention is given to diluted earnings, the reduction is typically slightly less, due to a sharper reduction in actual shares than diluted shares. In aggregate, both counts have been going down over the past year.

BITING THE BULLET. The second trend is increased dividend payments. This started in early 2003 and gained strength in May of that year with the reduction of taxes on qualified dividends. Since then many companies have initiated a dividend policy, with a majority of issues in the S&P 500 having increased their annual payment in 2004 and 2005. As a result, dividends are again in vogue with investors, with several new instruments and ETFs being listed to accommodate them.

The third trend is the reduction in issuance of stock options. To this end, many corporations have limited the amount of option grants, and are now utilizing restricted stock grants as a compensation tool. This will reduce future option expensing costs, but given the enormous number of options already in the hands of investors, the contingent liability of the exercising still remains.

The change in accounting rules enhances valuations, and comes at a time when earnings are strong. Similar to other changes, such as the goodwill impairment change (FAS 142, 2001), some industries and sectors will be impacted more than others. The inclusion of option expense in the Information Technology sector will significantly reduce earnings. However, the cost is a legitimate part of operations, and as such needs to be included.

This is an edited version of a report from Standard & Poor's Investment Services. A full version can be viewed here.